Gap Inc. (NYSE:GPS)
Q2 2009 Earnings Call
August 20, 2009 5:00 pm ET
Evan Price - VP of IR
Sabrina Simmons - EVP and CFO
Glenn Murphy - Chairman and CEO
Adrienne Tennant - Friedman, Billings, Ramsey
Betty Chen - Wedbush
Paul Lejuez - Credit Suisse First Boston
Edward Yruma - KeyBanc Capital Markets
Stacy Pak - SP Research
Jeff Klinefelter - Piper Jaffray
Laura Champine - Cowen & Company
Richard Jaffe - Stifel Nicolaus
Kimberley Greenberger - Citigroup
John Morris - Bank of Montreal
Lorraine Hutchinson - Bank of America/Merrill Lynch
Roxanne Meyer - UBS
Michelle Tan - Goldman Sachs
At this time, I would like to welcome everyone to the Gap Inc. second quarter 2009 conference call. (Operator Instructions) I would now like to introduce your host, Evan Price, Vice President of Investor Relations.
Good afternoon everyone. Welcome to Gap Inc.'s second quarter 2009 Earnings Call. For those of you participating in the webcast, please turn to slides two and three.
I'd like to remind you that the information made available on this webcast and conference call contains forward-looking statements including those identified in today's earnings press release which is available on gapinc.com, as well as other statements that express our expectations, anticipations, beliefs, estimates, intentions, plans and forecasts. Because these forward-looking statements involve risks and uncertainties, there are important factors that could cause our actual results to differ materially from those in the forward-looking statements.
Information regarding factors that could cause our results to differ can be found in our annual report on Form 10-K for the fiscal year ended January 31st, 2009. Investor should also consult our quarterly report on Form 10-Q for the quarter ended May 2nd 2009 and today's press release.
Due to economic and industry trends that could potentially impact net sales and profitability are difficult to predict. These forward-looking statements are based on information as of August 20th, 2009, and we assume no obligation to publicly update or revise our forward-looking statements, even if experience or future changes make it clear that any projected results expressed or implied therein will not be realized.
This presentation includes the non-generally accepted accounting principle measure free cash flow which under SEC Regulation G, we are required to reconcile with GAAP. The reconciliation of this measure to the GAAP financial measures is included in today’s earnings press release which is available on gapinc.com.
Joining us on the call today are Chairman and CEO, Glenn Murphy and Executive Vice-President and CFO, Sabrina Simmons. Now I would like to turn the call over to Sabrina.
Thank you Evan, good afternoon everyone. As we conclude the first half of the year, I’d like to take a moment to reiterate the four financial priorities that I laid out at the beginning of the year. First, deliver healthy merchandized margins. Second, maintain our discipline around cost management. Third, generate strong free cash flow and fourth, continue our focus on return on invested capital.
I’m pleased with how we performed against these priorities in Q2. Merchandise margin increased by 210 basis points. Operating expenses were about $50 million below last year and our ending cash balance are over $2 billion was driven by year-to-date free cash flow of nearly $600 million. Our focus on these levers of performance resulted in earnings per share of $0.33 versus $0.32 last year, and operating margin of 11.6% versus 10.7% last year.
For webcast participants, please turn to slide four. Second quarter net earnings were $228 million or $0.33 per share compared to $229 million or $0.32 per share last year. Second quarter effective tax rate was 39.4% and weighted average diluted shares were 700 million.
Turning to slide five, sales performance. Second quarter total sales were $3.25 billion, down 7% versus last year and total company comp store sales were down 8% in the quarter. Please refer to our earnings press release located on gapinc.com for total sales and comps by division.
Turning to slide six, gross profit. Merchandise margins improved 210 basis points, primarily driven by better markdown margins and less inventory sold at markdown. This improvement was offset by 60 basis points from occupancy de-leveraging. Gross margin was 39.7%, 150 basis points better than last year and gross profit was $1.29 billion.
Please turn to slide seven for operating expenses. Second quarter operating expenses were $913 million, down $52 million versus the prior year. The majority of the savings were driven by lower variable store-related expenses which came down in proportion to our sales decline.
Additionally we benefited by about $10 million from foreign exchange. Marketing expenses were $94 million versus $82 million in 2008 with the increase driven by Old Navy.
Turning to slide eight, inventory. We ended the second quarter with $1.5 billion in inventory, down 13% versus the prior year. Inventory dollars per square foot were down 14% versus the prior year. As a reminder, a key driver in the reduction in inventory dollars per square foot is lower average unit cost. Therefore the reduction in inventory units is less negative than the 14% decline in inventory dollars per square foot and we are comfortable with our inventory levels entering August.
Please turn to slide nine for capital expenditures in store count. Year-to-date, capital expenditures were $131 million. We opened 23 stores weighted towards international and outlet and closed 27 weighted toward Gap brand. Company-wide, we ended the second quarter with 3,145 stores and net square footage was 0.3% lower than fiscal year-end 2008.
Regarding cash flow on slide 10, year-to-date free cash flow defined as cash from operation less capital expenditure was an inflow of $589 million compared with an inflow of $354 million last year. Please refer to our press release for a Reg G reconciliation of free cash flow. We ended the second quarter with $2.1 billion in cash and short-term investments and no debt.
Turning to slide 11, our outlook for the third quarter. Though the economy is still challenging, as we entered the back half, we will began to turn more of our attention to driving traffic and improving our comp store sales trends.
As part of our goal to drive traffic, we plan to invest more in marketing, primarily at Gap and Old Navy. At Gap, we added an integrated marketing campaign for the relaunch of denim. What is different about this campaign is Gap is focused behind a single message for July, August and September, "Born to Fit". The marketing campaign consists of radio, outdoor signs and print ads. At Old Navy, we're continuing with the supermodel campaign and added one more circular and about a week more of TV in September.
Given the marketing plans I just described, we expect Q3 marketing expenses to be up about $25 million compared to the third quarter last year. That being said, I want to emphasize that we remain committed to our cost discipline.
Since the beginning of 2007 through the first half of 2009, we've reduced operating expense by over $650 million. In Q3 of last year alone expenses were down $95 million versus the prior year and as we said expense reduction opportunities naturally moderate overtime, as we anniversary these large cuts.
Due primarily to the higher marketing spend, and the anticipated lack of foreign exchange benefiting Q3, we expect operating expenses to be flat to up to $20 million versus the third quarter last year.
With regard to inventory, our strong inventory discipline has been a key enabler of our margin expansion. Our goal is to balance keeping our inventories in line with demand while allowing us the opportunity to drive gains in market share.
Given that objective, we expect the percentage change in the inventory dollars per square foot at the end of the third quarter to be down in high single-digits compared to the end of the third quarter last year.
Similar to Q2, given our lower average unit cost, we expect the reduction in inventory units at the end of the third quarter to be less negative in our guidance for inventory dollars per square foot.
Regarding share repurchases, given our strong free cash flow and ending cash balance in Q2, we will likely resume some level of share repurchases in Q3. For the full year, our guidance for the following metrics remains unchanged. Depreciation and amortization about $550 million, effective tax rate about 39%, capital expenditures about $350 million, new store openings about 50, store closures about a 100, net square footage declined about 2%.
In closing, we are pleased that in the second quarter, we delivered solid results against our financial priority. Looking ahead, as we focus more on improving our traffic in comp store sales trend, we intend to make some modest incremental investments in the business. That said, given the difficult economic environment, we will monitor the returns from these investments closely and remain focused on our operational discipline.
Thank you and now I will turn it over to Glenn.
Thank you, Sabrina. Before we hand the call over to analysts and to take some of your questions, I do want to make a few comments on the performance of Gap Inc. in the second quarter.
First and foremost, we were pleased with our results in the quarter. Obviously, the conditions we are operating are still very challenging to beat last year by $0.01 given the economic conditions everybody is operating, which is actually quite a feat and we're encouraged by that.
I think as we talked about at the last conference call, it shows the benefit we're getting from the new economic model we've been working on for the last eight quarters, some of what Sabrina referenced in her opening comments. What's really important is the fact we've taken out $650 million of SG&A and we've been disciplined on the four key financial pillars that all of us have been following here for the last couple of years.
Now as you look forward, we look to Q3, we as a the company to find the right balance between maintaining cost discipline and changing the trajectory of revenue that we've been on for far too many years. That's important to us. So in the third quarter, we're going to be making targeted, I want to make sure I'm clear about this, targeted selective marketing investments in order for us to be able to [grow] there and gain market share and again, we look at our total business that we have a number of different brands, number of different channels and this is not all going to happen at once.
This is a good time for us to be realistic on where we want to make those investments but work together as a team here in the office to strike the right balance between maintaining cost discipline and pushing to change the trajectory of sales.
I just want to close by giving you a couple highlights in our business going forward. First, we have had four Old Navy new store models we've been testing now for a number of months. The first two we did in November. We did two more in May. We now have enough evidence of the performance of those four stores that we will be doing 50 more Old Navy remodels between the end of August and the end of October.
Tom's business has I believe very strongly found the right environment for the Old Navy customer, found the right store layout that people appreciate. So our own financial data and consumer feedback have given us the confidence to do 50 more stores in the next two months.
Secondly, Gap relaunched its denim this month. While it was in the stores at the end of July, the official unveiling of the denim campaign, combined with some limited marketing was on August 13th. We feel good about the feedback we've heard so far. This is from customers first and foremost and from the fashion press. I think it’s a good first step for Gap to take its number one category, reposition it, do it in a Gap way and make sure we can offer great value on a key category which is premium Denim.
Piperlime will be introducing apparel to their website next month which I think is something that is an important development for us. Obviously the brand started off as a vertical brand for selling shoes, moved to handbags and now we'll be adding contemporary apparel to its site at the beginning of September.
We've got lot of designers and a lot of unique brands have come to us because what they like about Piperlime is it's not a commodity e-commerce site. It finds the right balance between e-commerce and social networking. Our team here has been working with a lot of brands. You're going to see us add those. A lot of customers have been asking us to add much more than shoes and handbags that we have currently for the last number of months and I think we're going to be happy to satisfy their needs because Piperlime truly is a unique site on the web.
Last comment, before we hand it over for questions, we will be celebrating our 40th anniversary tomorrow. 40 years ago in 1969 of August 21st, we opened our first store. It is a significant milestone for our business to celebrate 40 years of satisfying customers, a recognition of the strength of the brands, the ingenuity and the commitment of everybody who works here, and really the vision and the passion of our founders, the Fisher Family Doris and Don Fisher.
A little tit-bit, we will be dressing up the New York Stock Exchange tomorrow in denim, 1969 Denim and we’ve been honor that we will be allow to bring the closing bell at 1 o’clock San Francisco time in our offices here in front of all our employees.
I want to hand call over now back to Evan Price and I want to thank everybody and look forward to answering your questions. Thank you very much.
That concludes our prepared remarks. We will now open a call to questions. We'd appreciate limiting your questions to one per person.
(Operator Instructions) Our first question comes from the line of Adrienne Tennant, with Friedman, Billings, Ramsey.
Adrienne Tennant - Friedman, Billings, Ramsey
Good afternoon. I wanted to ask you about the real estate rationalization on the three year plan. What progresses you've made on it and what learning’s you’ve had? How difficult those landlords to deal with or how easy are they? Thank you.
I would say that, it’s always going to be a bit of a challenge, its one of the few parts in our business where it takes two parties to come to an agreement. So, we’re making progress, certainly are following our three to five year plan we put forward in terms of repositioning the stores were necessary getting between 10% and 15% reductions square footage.
Actually having a plan now, so when capital needs to be appropriated, decisions need to be made, I think it so much easier now on a brand-by-brand basis. Also I’d say on a country-by-country basis to follow strategy that the business has approved and is attempting on a quarterly basis to execute on.
We just anniversaried last month, the first plan we put together which was in a summer of 2008, so like anything, I have meetings with all the real estate teams in the last 30 or 60 days. We made minor adjustments to the strategy, but I think the general spirit is clearly not changed one bit.
We still believe that in general the economic conditions make this a slight net positive environment where somebody with 40 million square feet and different brands, and I would say a clear strategy that we've been able to go to the landlord community and explain to them what our intentions are, what our goals are and why.
My experience in real estate is even though it takes two parties to come to an agreement, if you’re clear and you’re consistent then I think you can ultimately get what you want to get out of your strategy so, so far so good. I think feel good about the team we have in place and the execution they've delivered after one year of a three to five year plan.
Our next question comes from the line of Betty Chen, with Wedbush
Betty Chen - Wedbush
Glenn, I was wondering if you could give us a little bit more color about the premium denim at the Gap brand. In particular, we’ve been noticing some inventory positions and how you feel about that and in particular also staffing. I know you have done a great job of trying to control store staffing according to sales trend. Given this is a rather high touch point item, how are you thinking about staffing needs to make sure that customers are aware of the new merchandise and to serve their needs appropriately? Thank you.
First and foremost I would say that this has been 18 months in the making with Marka and Patrick Robinson, sort of leading the charge, there’s been others involved. I think they made the right decision choosing the category of the size of Denim, the historical and heritage importance to Gap of the Denim category and wanted to be quite honest that over the last number of years regardless of the odd attempt to reposition in the last five to seven years, really nobody is coming and really try to do complete reengineer and redo the category. So I think that made a lot of sense to me.
Obviously this is the right time. We think of August as a good month for denims, so the right time to relaunch it. The thing I'm most pleased about is that the team brought it right down to the store, and I think it's easy just to rely on long lead, magazines or weeklies or other media that you can use to announce something that you put a lot of effort to and I think that you actually have hit the mark.
I think that the fact is, right in the store, it's highly visible as you're commenting. I think that is important to us and I think so far, on those two fronts, the work that went behind it, the fact that they focused on fits, the name of the campaign, the Born to Fit and execution at the store level; I think on all those marks, I actually feel good about what the team did.
Now its way too early to make any predictions of what's going to happen. Denim is one of those loyalty categories and people have habits that are deep rooted. It takes a while to convince people to change their current buying patterns, so we're going to be patient to a point and read the information as it comes to us.
So on your two questions, specifically on the inventory, I mean, they had a huge task and Sabrina and I were fully aligned with the teams spending time with them on this task they had. The first one is when you have all of these new fits, basically to different degree, but in general, all new fits in women and a lot of changes to the fits in men's trying to predict washes and styles and fits and be completely accurate is, no question, [present] a bit of a challenge for the team.
I'd say there are some pockets where particularly big denim in markets like LA and New York where small sizes have certainly resonated very strongly. There are pockets where the benefit of hindsight a few month ago, you might have changed the allocation but I'd rather have them try to do it as best of the data they had and then learn from it and then we can manage that through the replenishment cycle. So there have been some pockets like that.
In terms of labor, you are right to access or assert, we have been managing our labor accordingly for the last two years, put a new labor management system in place which has been hugely helpful to us, but in the Denim relaunch the Gap team took a couple of hundred stores, maybe a few more and actually put incremental labor. The training they did was phenomenal which I was able to see.
The incremental training on the denim specialist that they have in their stores, and they did put some incremental labor in actually; one, to get people who first come in, who are probably thinking of trial. How do you get them to actually buy and then how do you turn them into a loyal customer. That's in a large part driven by the product, but also by the kind of service you have and the ability for somebody to sell you and convince you of the right style that you're buying. So there was some work done on labor that I think was smart and we're currently reading whether that was an effective use of our SG&A and then we get the right return for it.
Betty Chen - Wedbush
On the smaller sizes Glenn, are you able to get back into position pretty quickly?
We definitely did some smart things. We took some positions on fabrics, so we had fabric outside of the actual goods that were produced that got delivered to the DC and then into the store. So they're moving, I mean the minute they had a read and that looked at all like maybe the smaller sizes were the ones that were resonating, which by the way is good for us. I think that indicates, maybe a bit of a younger customer coming in at the lower end of our 24 to 34 year old demographics.
So I think they're moving as quickly as they can. I think there was a little bit of inventory that's coming into September to try to feel that selective amount of other stocks we're having on the small sizes and [mostly on] dark washes. So they are working really hard to try to get that fulfilled and I think so far the information I've had is they've been able to move a lot faster than we move historically. And in September we'll start to see definitely new inventory coming in to satisfy some of those better stocks we're dealing with.
Our next question comes from the line of Paul Lejuez with Credit Suisse First Boston
Paul Lejuez - Credit Suisse First Boston
Just wondering when you guys are talking about taking back market share, should we assume that there is going to be any sort of more aggressive pricing components to that plan? Second, I guess Sabrina, just one wondering if anything has changed structurally where you wouldn't be spending more SG&A dollars in the fourth quarter versus the third quarter.
I'll start with the pricing, Paul. I think that there is certainly a recognition in some of our brands, our value brands led by Old Navy and by our Gap and Banana Republic outlet in factory stores that we have to make sure, given the current consumer mood and the fact that value players in general over the last number of years have been gaining share. We got to make sure against the specialty apparel business and the non-value players. We have to make sure that those two brands are sharp on price and are actually delivering the kind of pricing message to the consumer that we've recently redone in some of the prices strategies we put forward.
When you add it all up, I think it's probably not a significant difference to total AUR, but I will tell you those two brands more than anything else we put a lot of time into the third and fourth quarter. How was pricing going to show up? A big part of pricing for us is the communication of it. My observation is that from our perspective, we're not very good at that. You will see some changes in the back half in terms of making sure that we stand proud when we actually have a great everyday price.
You will see some of that at the outlet business and in Old Navy, but we don’t want to leave Banana Republic and Gap on the sidelines. There is certainly some of the work been done in their business again not as much lowering price, but making sure where we believe we have an advantage versus the competition. Because the category we believe we should be taking market share from a predetermined number of brands.
We got to make sure that we don’t shy away from that. As I am sure you know it’s a fine line between how the brand shows up every single day and what you do when it comes to the value offering you have, but I can’t control the environment which in we're operating, so if I’m going to air, I’m going to air to make sure the value part of all our brands where it exist, comes through when it’s clear to that target customer.
Then with regards to your expenses Paul, what I would say beyond our Q3 guidance we just gave is that it is important for us to emphasize that we remain incredibly committed to cost discipline internally. We look at that broadly speaking, so as you think about one of our biggest and most important line items on our P&L, which is our average unit cost of our merchandise. We feel very confident that those savings are going to continue throughout the rest of the year. There are other pockets, where we still see opportunities in the areas of, example as logistics or occupancy and we are going to pursue all of those.
On the actual SG&A line item itself, it will be tougher to actually see any sheer reductions in dollars on that line items for kind of the reasons I pointed out which we are anniversarying now many, many quarters of deep cuts and we are taking that position at going forward because its our objective to improve our sales and comp store trend.
We will be making selective investments in marketing, of course we want to see a return on that, but there will be selective investments in marketing. Then finally again, if we achieve our objective of improving our sales trend, that variable store-related expense, will move in proportion to sales. If we actually achieved our objective of improving our sales, you’re going to get less saving on that line item.
Our next question comes from the line of Edward Yruma with KeyBanc Capital Markets.
Edward Yruma - KeyBanc Capital Markets
Can you talk a little bit about the performance metrics of the Old Navy stores that you refreshed already? What gives you the confidence that you see that same type of return on the 50 stores that you are going to refresh? Thank you.
We made a decision, not to make the decision incrementalized by two stores every quarter and wait until we had the evidence which was indisputable that we should maybe, step up and do more. We’ve done four, the first two were done in November. There is a number of different fronts. There is the qualitative and the quantitative side to it, and from our customer feedbacks so far in terms of the customers we served as they come in the store and the people who we're now drawing from, who maybe used to shop the store no longer did and the new customers who come in, that’s been an encouraging sign for us at all, maybe.
The other part that we've looked at is the productivity inside the box. The fact that while it’s a much more appealing looking store from a consumer perspective, in terms of the visual aids and the design and everything of store. We wanted to make the store more productive. That’s a little secret of retail and when people come in and actually can you get 10% or 15% more productivity of the box whether it’s by design and fixtures or maximizing selling square footage of the expense of back room and all of these things we try to work with the new design.
I think Tom and the team did an excellent job of not only putting the look of the store in place but also trying to follow those principles that trying to maximize productivity by adding more selection inside of a box, was previously of certain size, now there’s more available inside of it. That was important to us.
There is a whole bunch of different ways looking metrics, but at a very simple level for me, was we looked at what was the trend of those stores prior to the opening against a comparable store group, a universe. Total fleet was one way of looking at it, versus a comparable group, control store group and how did the trajectory change once we opened the store and made the investment and obviously [clear to us], we have minimum return on capital thresholds we use and Tom met those and has actually surpassed them in all four cases.
Now you have, sort of everything being aligned that pointed to myself and Sabrina and Tom most importantly and his team and that he struck a chord with those four stores. Now we're going to go out and try 50 more. I’m actually out with Tom and the team next Thursday and Friday, we're taking off to go to four markets where some of the first stores are going to open by the end of August and we'll get all 50 done by the end of October. We'll be in a good position of [commendable] that we'll put as much rigor and time and analysis with customers and with just pure metrics and productivity into these 50, so we can assess what decision makes sense for 2010.
Our next question comes from the line of Stacy Pak with SP Research.
Stacy Pak - SP Research
I wanted to talk about July and also just product. I guess one of the things I was wondering Glenn, I was looking at Old Navy in July when you guys had that 50% off sale going on and then you still reported a negative 8 comp which was a pretty big decline in run rate. I know the margin was good and Old Navy was a driver but kind of wondering, how you're thinking about the tradeoff on comp versus margin?
Is that one of the things that could change going forward? I guess also just on the pricing, is $34 denim at Old Navy, really the right price because it looks pretty high to me. Traffic really hasn't improved, so other than marketing what are you going to do to kind of get traffic going? Could you grade the fall product on Old Navy and Gap? Just from a qualitative perspective give us your feeling of how good it is. Thanks.
There is a lot there. So let me try to take to take a couple of them on. I think Sabrina will also be able fill in and answer some of you questions. First thing on the 50% off, which is, what we do when we need to, not [necessarily] traffic driving event. Sometimes we put 50% off and incremental POS on some of our clearance.
I think you heard Sabrina and she will clarify for those who weren't on the sales call that took place few weeks ago to talk about July sales was that we've now been able to do selective investments like that where we think is appropriate. We are in clearance season and you may see a 50% off. That may only be taking place in a 150 of our stores, but as a year ago, that would have been a universal generic decision to do that regardless of inventory levels.
Marked down inventory for Tom's business and Old Navy was actually low. The inventory markdowns in July that's part of the reason why he wasn't able to get to the comp number versus last year. Sabrina will touch on that. That was a purposeful decision. So in very few stores, it happened. We had to use an incremental 50% off POS to move through the inventory. So that's true, but it was selective.
On the denim piece, the premium pricing for Old Navy denim is $34.50, but its day in day out pricing on five-pocket in $29.50. So there are two price points at Old Navy. I think that Mark Breitbard and Tom feel that that's the right price. We have promotions going on like we do this week where all denim has been sold for $19 at Old Navy for about 10 days. We just came off, we are just completing now where kids denim was for $10 for about 10 days.
I would say in denim, they think they have an everyday price that is competitive, but also I think they used the [promo lever] every now and then to really drive home the message with consumers to generate traffic or in this case conversion and keep that category very solid. So I think that that approach to me makes sense, particularly the majority of our skews and styles and sales are in the $29.50 bucket.
I think I just emphasized that for the Old Navy division, we did see traffic improvement quarter-over-quarter. So, in Q1 for Old Navy our traffic was a negative six and in Q2, it moves to negative one. So we were pretty pleased with that.
Just to underscore what Glenn said the POS events at Old Navy in July were much about attracting traffic, then trying to move inventory since we were very lean on markdown inventory purposefully as we are trying to drive better quality of sale.
With regard to balancing merchandise margins and comp Stacy, I think it's always a [delicate] balance and I think 2008 was characterized by really cleaning up the business having a lot less inventory and probably accepted more as a negative comp to drive that healthy business and margin rate. What you're hearing one and I talk about now is because we've achieved excellent margin rates now. We really are putting more of our focus on comp and while we do that, the goal would be to maintain the healthy margin rates we've achieved. So we're starting to move out of the phase into another where we are going to put more focus on improving that comp trend.
Our next question comes from the line of Jeff Klinefelter with Piper Jaffray.
Jeff Klinefelter - Piper Jaffray
Just curious, either Glenn or Sabrina if you could talk a little bit more about your spending plans going into the second half. Can appreciate that you are very carefully approaching this stepped up level of spending and you are going to monitor the response carefully. Could you share little bit more about what you are looking for actually to get that return? Is this going to be a comp feedback loop? Is this going to be margins? What would tell you whether not to keep going or to pullback on that spending as we get into the third and fourth quarters?
I'll just comment for a second Jeff and then Sabrina will also be able to answer your question. One, it differs by brand obviously in terms of what the ultimate goal we're trying to achieve. We talked about market share which is what you heard us speak about in the opening comments and I believe there are some quotes that were consistent with that in the press release, which is what we are recognizing now and believe we put a lot of effort in the last two years to change the economic model of the business.
That should have taken two years. I think it wasn't for the economic conditions we've been operating for last fifteen months, maybe we'd be having this conversation sooner, but I think its been our view that time well spent, lost a little bit of time because of the economic condition but we really ratcheted down and tightened up the economic model.
Now its clear to everybody, not just us in management that the only way that we will be satisfied and be able to produce the kind of earnings we want to produce and we set for ourselves is to find a better balance between the trajectory of our top-line while maintaining the new culture we've introduced in the business of not being afraid to take out cost, recognizing the value of that and the flexibility it gives us as a company to take those cost savings and reinvest them appropriately to change top-line performance.
So again, by brand, it's going to be a little different in terms of the sequencing, what we've talked about previously as Old Navy in March. It might have seemed little premature, but we felt the Tom and the team had done enough work at Old Navy to feed them some amount of marketing in order to change their trajectory of sales and I think so far so good. I think we’ve explained to people what happened in July and people can judge us on what happens in August, September and October going forward, as we continue to believe that that business is poised with it's new economic model to change the top line trajectory that it's been on.
Now Gap in a very small moderate way, we decided to make some investments in marketing and denim and to see if we can use that as a starting point to get its business back and going to a direction we would be pleased with. The expectations internally of top line versus margin differs by brand, I would think obviously Old Navy, a little more expectation from our end on top line to get the growth going on behalf of the company. What we get paid money to do is find that balance between all of these key levers to make sure we can get the earnings that we feel are acceptable to drive that performance in the bottom line of the company.
The only thing I will add to that is just a reminder that we're staying really disciplined about our fixed and overhead expenses, so there is no increases there at all. What we're really talking about is the level of savings that we were getting from our variable store related expenses as our sales has declined.
If we meet our goal, those savings are just going to be less and that’s just a natural thing that happens when you're moving more units and sales through your stores. Then the second piece of course is the marketing piece which Glenn talked about, which we'll be watching ultimately, traffic and comp are the clearest indicators at the end of day if you're getting a return. We're making those investments to drive that very objective of improving our sales trends.
Our next question comes from the line of Laura Champine with Cowen & Company.
Laura Champine - Cowen & Company
I think this is general follow-up to questions you've been asked, but of the 25 million in incremental marketing expense, how much of that is just related to the new jeans launch and how much of it will carry over, let's say into the third quarter next year or even if you can talk about coming quarter sequentially? How much extra spend is related to that launch?
We haven’t quantified each campaign, but what we have said that the 25 million incremental spend to LY in Q3 is driven both by Gap and Old Navy. Roughly speaking, its fair to say that the increment is probably about the same at Gap as it is in Old Navy. In Old Navy, we’ve got another week of television and one more circular than we have last year. At Gap we have the campaign, which is really a new campaign, it really has much more prints than we have last year, it has radio, non of which we have last year.
It’s kind of evenly split and then there is some movements in the other divisions as well, but it's primarily those two. We haven’t guided beyond Q3, we tend to do that
Laura one quarter at a time, but I think the scene here is, we are investing in marketing where we believe we're going to get the return. We will be watching every day and every week and the results of our business to read just how much we want to lock into holiday. That’s why, we still had some levers to move there and we’ll give you an update as we move closer to holiday at the Q3 call likely.
Our next question comes from the line of Richard Jaffe - Stifel Nicolaus.
Richard Jaffe - Stifel Nicolaus
Just a follow-up on the Denim and the early response and the leanness of inventory at Old Navy, obviously my experiences are anecdotal but, I’m hardly young or small and yet couldn’t find either the jeans I wanted in several stores in New York, sold out. Old Navy, you're clean as a whistle or may be I’m late for the season but can't find any shorts. They are simply out of stock. Have you starved the stores? Have you taken just one step too far? If you feel like in certain categories you have, what’s the opportunity to get back into an inventory position in the key category?
At Old Navy, no question I think and strategically tried to make sure we managed inventory particularly versus last year when it came to the markdown amount. Now if you went in the last two weeks to New York and couldn’t find shorts, I know summer came late in New York that probably is not going to give us a lot of angst. I think it’s a disappointment to lose a sale and to disappoint a customer. Those kind of things are nerving to us, but definitely if you were in what we would considered to be hotter regions, we have a new program, we put into place last year and about a 150 Old Navy stories where categories like that, categories you'd expect to find you around in parts of Texas, Arizona and Florida.
We will sell those in about a 24 foot section in all those stores which we never did before. Still would have like for you to say to me that in the second week in August, or at the first week in August you were able to find shirts, that’s disappointing but I am not surprised. We start to wind down that category and shift into our fall product.
On the denim, that’s a disappointment and I’m sure I'll have Evan track you down later on have a conversation, to get you to the exact store, tell me exactly what size you wore, what you were missing and we'll look into that. It's a big brand and there's lots of stores and at any given moment that might happen, regardless, it should not happen. We definitely put enough inventory and where we would be self-critical would be that we probably did not anticipate in the zero to two sizes in some fits, in some washes in women's, that maybe the acceptance would be so high.
That's a little weak, again. New York and LA mostly we saw that and we're working hard, as somebody previously asked us, about how quickly can we get back in stock on those. We are working 24/7 to make sure that we get back in because we had fabric waiting, so we could read it and then go to fabric quickly and then get back in. It's not a perfect business, with that said though, knowing our passion and mine in particular for not disappointing customers, I'll make sure Evan follows up with you.
I would not say we're starving the stores but I also would say to you as we move to this next phase of trying to get the right balance between a disciplined cost culture and trying to shake off the last number of years when we were not gaining market share, going hand in hand with that is Sabrina's ability to work with all of our brands to make sure the inventory follows suit and we have principles behind that.
We're trying to make sure we have the inventory because otherwise, we're just going to be talking to ourselves. We think we can drive incremental market share gains without at least having the inventory support. So Evan, you get back to me on the denim and the store and I'll take care of that and the shorts, we'll see.
Our next question comes from the line of Kimberley Greenberger with Citigroup.
Kimberley Greenberger - Citigroup
You've achieved very impressive cost of goods sold savings over the past year and a half. I'm wondering if you can help us understand what sort of cost of goods sold saving you are looking to achieve in the second half of '09. And then as we get into 2010, on the back of two years of really great savings, did you see an opportunity to further lower your cost of goods sold?
Kimberley, I'll talk a little about 2010 and then I'll have Sabrina talk to you about the back half. I'd say the first year and you are correct, it's been pretty close to two full years. The first year, if you remember what we said, publicly was a correction and that we had enough evidence and facts that we were not getting the costs. We should have been getting so whether that's our fault for not being focused or being poor negotiators or in some cases, not being structured properly.
You may have heard us said we had letting some people design negotiate fabric which is nothing but advantageous to the mill in china. So I think we've changed our structure internally, who does what, who is in charge, professional negotiators negotiate cost and that was the first year. I would say it was mostly us getting back to where we should have been.
Now with the tailwinds we're getting, with the change in the commodity pricing and everything else and the capacity opportunities, we are probably riding a similar wave to everybody else when it comes to getting cost out of our business.
Now 2010, just a couple of days ago we were in our second or third session with our team in procurement around the world and talking about how are we going to make sure; one, we never give up the gains we've done. And what are other opportunities for us to be able to meet with our vendor partners and find ways to squeeze out efficiencies inside of the complete supply chain from the mill where the fabric comes through all the way down to the back door of our store.
That work has just begun. I don't have a number for you. All I'm here to tell you is that, we don't want to be two year heroes. And last year again, I think we've rolled with everybody else but definitely in 2010 we have to make sure we bring our size to market, we are the biggest in the terms of the category in which we operate in a lot of markets, make sure we're flexible in the countries in which we operate. We're in 48 countries right now and make sure that our ingenuity and our tenacity allows us to find ways to make sure that that line item in the company which as you rightly said has been important to us the last couple of years continues to contribute.
I guess in the second half, I would just add to that that we have, as Glenn said benefited not only from our own work internally that we've done to improve our processes, but a lot of just natural economic tailwinds in the area of average unit costing in 2009 and we feel really comfortable that throughout the second half we're going to continue to get a very healthy meaningful level of average unit costing.
Then just to reiterate again what Glenn has said, we are in no way giving up in 2010. What we recognize is probably lot of those really big nice tailwinds we've gotten are going to start to diminish, but that just raises the bar on our internal teams and our processes to find more creative ways to work with our vendors to continue to get some of that saving.
Our next question comes from the line of John Morris of Bank of Montreal.
John Morris - Bank of Montreal
I guess this one is probably for Sabrina; we've talked a little bit about it, but let me ask the question this way, the delta on inventory units now running less negative in inventory dollars. What had that trend been in units relative to dollars per square foot? Is this a bit of inflection point? Is that what you're saying here? Glenn could we see Gap brand actually back on TV by the end of the year? Finally, approximately what percent of the Old Navy fleet could be remodel candidates?
On the first part John, we're just calling it out and then just going back to even the prior question, because of the combination of the work we've done internally to improve our average unit costs profile and then with the tailwinds coming into 2009. The average unit cost piece of that inventory dollar per square foot down is much more meaningful than it would be in most years. So we just thought it's important to call out that there is this differential because we don't want people feeling like our units are down 14% because we do feel comfortable that we have the units available to us to meet our goal in the third quarter of improving our sales and comp store trend. That was really the piece of calling it out, there is really no change from the first half as we go into the second half with regards to the level of AUC, so we are not really in a change in inflection at this point.
On the other two questions John on Gap, going back to television, one thing we have attempted to do. I think Old Navy, we’ve been pretty clear on the right mix of the media. It’s going to need to be successful and to get this market share goal of ours at Old Navy. I think for the most part, Tom and his team, we've pretty much landed the plane when it comes to Old Navy.
On Gap, given the fact we just did this moderate investment in marketing for the denim relaunch and use the number of different media, did not use television. I think we’ve been very impressed with the Gap customer and how much they get their information is no big to surprise anybody on social networking media. I think that's been a good lesson for us and using radio and using print ads.
In the next couple of weeks, we are going to have to sit down in a serious way and figure out if television is part of the fourth quarter and if so you talking to your new agency, how would that come across, does it make sense? Can we buy it effectively to get the right GRPs? These are discussions that I think we are going to have, what we’ve already had. We are going to have to step up the conversation and make sure we can determine that so I am not taking it off the table. I think it’s worth considering, but we haven’t really decided fully if that’s going to be a part of the decision going forward.
On the Old Navy fleet, what we decided to do was the 50 stores that will be completed between the end of August and the end of October are for the most part, the sampling of the 1000 store fleet. From there, we are going to find out whether those are stores in middle America or it's in strip or it’s in the mall or it’s 15,000 square feet or it's 20,000 square feet. I think we are looking at how Tom’s business and those stores respond again, using the metric we talked about earlier which is how much does the sales top line comp trajectory changing against the control group, so we’re going to learn a lot.
I could sit here today and say I don’t think there is 1000 stores will that be candidates that we model, I’m almost pretty certain about that given the fact we added a number of those stores in the last three to five years, With that said, I’m hoping that when we think of down sizes, which Tom has a disproportionate amount of our downsizes and repositions which in the 50, we have a few of those, where stores have been downsized and remodeled and stores have been repositioned with the new look.
I think that’s really where my focus is, take the square footage out, put the new look in and also move the store we located, either in the same center or across the street and put the new look in. I think those are in the 50 and we'll get a good read in the next three to six months on that.
Our next question comes from the line of Lorraine Hutchinson with Bank of America/Merrill Lynch.
Lorraine Hutchinson - Bank of America/Merrill Lynch
Just wanted to follow-up on the product cost reductions that you are expecting and your strategy for those. Do you plan on giving some of it back to the customer in terms of higher quality or should we see the entirety of that come through with the gross margin line in the back half?
It’s a mix Lorraine, to be honest. I think we don’t set out with any purposeful strategy, our design team and our merchants do need to know and do know exactly what is the assortment they want to put forward and what is the quality they want to see. I think that where we got to be careful is on two fronts; through great negotiations and brining our leverage to market and our ingenuity if we were to save x percent on something. Does that necessarily mean that you are going to get paid if you put in the quality, that’s a good question and we have been testing a little bit of that in the last year. We need to know that answer whether it’s in quality or in fashion, we need to know that.
More important one to me, is to make sure, if we get a reduction in cost, is to make sure we don't have unless it's strategically important and driven by pricing architecture, don't just lower your price. Which when you have a business that has been driven in the past by IMUs and not driven by disaggregating what an AUC is versus an AIR and an AUR, that could be a dangerous situation for any retailer who does not disaggregate those.
For us, we're watching the competition very closely. We want to make sure we understand the people in the value channel, and I know people watch much more closely that they used to. How are they treating their pricing and do we need to respond one way or the other? It's a long way to say to you that it can go back in the quality if we think it's justified, it's what the customer wants, it differentiates us, it makes the product unique and we can get paid for it. Also I want to make sure that we don't just lower prices because costs are down because the competitive landscape and the people we watch will drive pricing, not the reduction in cost.
Our next question comes from the line of Roxanne Meyer with UBS.
Roxanne Meyer - UBS
My questions have to do with Gap. I know it's only been a week, but I’m wondering if you can let us know if you're new denim initiative is in line with your internal plan. Also whether you can comment on whether customers are buying tops as their buying the denim. And then secondly, while denim is a key driver at a big part of your mix, it's certainly far from everything. I’m just curious to hear about how you think about the rest of your assortment at Gap and what inning you may be in, in terms of any repositioning? Thank you.
We'll obviously talk a lot more about the full month when we do August sales and we really just launched the denim in earnest together with a campaign on August 13th. It's really too early to give a read on that, except to say, the early signs that we even talked about when we had a little bit of it out in July for a week. We're pretty happy with the early reads on it, but it's early in the gain.
I'll tell you that in women, the good news is we have established which are the big sellers. So to the point that we've been talking about an inventory, we now know which fits, we want to go out and chase. Examples, the biggest seller is long and lean. The always skinny is doing really well. So those are ones, we've established kind of where we need to go in terms of chasing into more inventory.
Our tops to bottoms, we're always hoping of course our core is in our bottoms and really establishing loyalty in bottoms and then hallowing to top. So that's continuing strategy and we hope that our fall product which is just coming out there that the consumer votes well and we'll talk about our August sales when we get there. What was the last piece of your question?
Roxanne Meyer - UBS
About the rest (inaudible)
I think most of that we’re going to cover off on august sales, so more to come on the denim.
We've been asked [before] about Gap product; we've never probably use the scale based on innings, but we've been asked before about it. We've got a fairly high degree of confidence in Patrick, the design in New York and a course on the Marka and her leadership here. You'll never get to the ninth [inning]. The Holy Grail is that you get to certain inning and you just keep adding and adding and improving and trying to make the right adjustments to your product to make sure that you're always moving the business forward and always find the ways and differentiate and satisfy those customers.
In general, I would say the Gap team relative to any of other brands is further along in terms of the panel, the panels we do with the customers, the research we do in terms of speaking to them, the amount of time we spend in stores and talking to them while they are actually in our stores shopping. They are the ones of our three brands that are furthest along and as part of the reason we mentioned in the last conference call, we decided to make this moderate investment because we wanted to not only get denim re-position but more of our customers in our stores, seeing the new product we put together and hopefully those two in combination over a period of time will change the trajectory of those sales.
Our last question comes from the line of Michelle Tan with Goldman Sachs.
Michelle Tan - Goldman Sachs
I just had actually a quick follow-up for clarification to Jeff's question earlier on the expense side. I was wondering if you could give us a sense whether you are comfortable with short-term deleverage on the marketing investment in the plan of driving longer term and sustainable sales growth whether you are really expecting a more immediate return on the dollars that you put out on the marketing side?
It's a great question. It's funny, we've been talking about this for the last six months in advance of making some decision. We have gotten pretty decent in the last two years at trying to understand the levers of our SG&A in the business and certainly to let you on our internal secret. We made it clear to everybody here is that if you are going to get money and it's intended to drive incremental gross margin dollars, you better drive incremental gross margin dollars.
So to say the people are on a short leash, I think would be a good statement. Tom certainly felt that in March, The minute we decided to do that and introduced new campaign with the modelkins and give them a little bit more fire power to get his word out to drive incremental gross margin dollars. He from that day on was on a short leash, and I think it was our ability to just say how much can we give people a chance for us to come across as being patient, because we know this is important, but at the same time people know that we have expectations and that if we're going to put the money forward people need to be able to change how those two key number, sales and gross margin dollars can contribute in order to pay for the incremental SG&A.
Our management accountability for Sabrina and myself is not to overreact because we have to appreciate the position we've been in the past for the same time, we are not going to exert a huge amount of patience. We want people to know this is important. By the way, everyone in our business, Tom, Marka, Jack, Art, Toby and our international presence, all understand that this is a goal of ours just to find a right balance between the new cost culture that everybody here has embraced and also the need that the company of this size with its history and its prominence needs to go out and actually start pushing its weight around and start gaining market share and doing it its way.
So the team at Gap, we're going to watch it carefully. We know how to read the metrics, but more importantly, we have shown the flexibility that when we don't believe we're going to get the top-line which would be unfortunate [or get] therefore gross margin, is what levers can we turn to in order to protect the earnings in the company.
Great, I'd like to thank everyone for joining us on a call today. As always, the Investor Relations team will be available after the call for further questions. Thank you.
Ladies and gentlemen, thank you for joining us for Gap Inc.'s second quarter 2009 earnings conference call. You may disconnect at this time.
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